Question

Explain in detail how diversification can reduce the risk of a portfolio of assets to below the weighted average of the risk of the individual assets.

Answer 1

Portfolio of assets forms after a grouping or combination of different types of financial assets like cash equivalents, bonds, stocks, currencies, and commodities. It might also be another type of securities like houses, private investment, and so many other things(Zakamulin, 2015). Different people/business have different preference when it comes to the management of it, some choose to have a financial professional look after it while some manage it by themselves. Regardless of what the choice is, one should always look out for personal objective and risk tolerance. Diversification helps in the reduction of risk.
Diversification doesn’t just mean that you own a lot of assets of multiple businesses and hold onto it. But rather with the use of diversification, all the unsystematic risks associated with the asset should and can be eliminated. These unsystematic risks can be something that is unique to that business like protest, miss-management, shortages of things for manufacturing and so many more.
Consider that you have a secured savings of $400,000. Now, as you build your portfolio, it’s crucial to consider the effect on portfolio performance and volatility due to diversification. The statement of not putting all your eggs in one single basket proves significant for having a successful investment and return from it. A proper allocation plan ensures that the portfolio is diversified with a mix of investments. All this contributes to better returns and reduced risk. Scattering out the cash you’ve at hand on stocks from Nepal, and other international market helps in the diversification process. For bonds, different levels of government from different parts can be sought while cash can be held not just in one financial institution but spilled into multiple.
All those help in the reduction of risk and keep the weighted average below the two extreme ends (highest and lowest). An example to justify this further would be:
Consider a total of $10,000 wealth is split in the following way in the portfolio:
Company A: $5,000 (50% of total wealth)
Company B: $2,500 (25% of total wealth)
Company C: $2,500 (25% of total wealth)
Considering that the expected return of Company A is 20%, B is 3% while for C it’s at 10%. Weighted Average would then be:
0.5*20 + 0.25*3 + 0.25*10 = 10 + 0.75 + 2.5 = 13.25
The weighted average calculated is lesser than the two extreme points (high of 20% and the lowest of 3%). However, we can note that the one with the most investment in dominating the weighted average. The further calculation can be done to calculate the risk involved in the same as well. With the investment diversified the risk of losing out everything in extreme cases is removed as well as there will be other investments in other different entities(Witt, 1978). It is worth noting that diversification helps in removing the unsystematic risk associated with the project. The other risk type being systematic risk is something that impacts the entire industrial sector and can’t be done something about it(Goetzmann& Kumar, 2008). But identifying the unsystematic risk and diversifying the investment such that to avoid that risk adds a lot of value and decreases the risk involved as well. All the reasons above are how diversification can reduce the risk of a portfolio of assets to below the weighted average of the risk of the individual assets.